What Is Amortization?
Amortization is the process of spreading a loan over a series of fixed payments. The loan is repaid at the end of the payment schedule.
Learn more about amortization and how it works.
What is amortization?
Amortization refers to how loan payments are applied to certain types of loans. Typically, the monthly payment remains the same and is divided between interest costs (what your lender receives for the loan), reduced loan balance (also known as loan principal payment), and other expenses such as property taxes.
Paying off the last loan will pay the final remaining amount of your debt. For example, after exactly 30 years (or 360 monthly payments), you will pay off a 30-year mortgage.
Amortization tables help you understand how a loan works and predict your outstanding balance or cost of interest at any point in the future.
How amortization works
The best way to understand amortization is by reviewing an amortization table. If you have a mortgage, the table has been included with your loan documents.
An amortization table is a schedule that lists each monthly loan payment, as well as the amount of each payment that goes to interest and the amount to principal. Each amortization table contains the same type of information:
- Scheduled Payments:Your required monthly payments are listed individually per month for the life of the loan.
- Repayment of principal: Once interest is applied, the rest of the payment goes towards paying the debt.
- Interest Expenses: Of each scheduled payment, a portion goes to interest, which is calculated by multiplying the remaining loan balance by the monthly interest rate.
Although your total payment remains the same each period, you will pay interest and principal on the loan in different amounts each month. At the beginning of the loan, the interest expenses are the highest.
As time goes on, more and more of each payment goes to your principal, and you pay proportionally less in interest each month.
Amortization table example
Sometimes it helps to see the numbers instead of reading about the process. The following table is known as the amortization table (or amortization schedule). It shows how each payment affects the loan, how much interest you pay, and how much you owe on the loan at any given time.
This amortization schedule is for the beginning and end of financing a vehicle. This is a $ 20,000 five-year loan at 5% interest (with monthly payments).
|Month||Balance (Start)||Payment||Principal||Interest||Balance (End)|
|1||$ 20,000.00||$ 377.42||$ 294.09||$ 83.33||$ 19,705.91|
|2||$ 19,705.91||$ 377.42||$ 295.32||$ 82.11||$ 19,410.59|
|3||$ 19,410.59||$ 377.42||$ 296.55||$ 80.88||$ 19,114.04|
|4||$ 19,114.04||$ 377.42||$ 297.78||$ 79.64||$ 18,816.26|
|. . . .||. . . .||. . . .||. . . .||. . . .||. . . .|
|57||$ 1,494.10||$ 377.42||$ 371.20||$ 6.23||$ 1,122.90|
|58||$ 1,122.90||$ 377.42||$ 372.75||$ 4.68||$ 750.16|
|59||$ 750.16||$ 377.42||$ 374.30||$ 3.13||$ 375.86|
|60||$ 375.86||$ 377.42||$ 374.29||$ 1.57||$ 0|
Types of loans for amortization
There are several types of loans available, and not all of them work the same way. Installment loans are repaid, and you pay off the balance over time with consistent payments. They include:
Auto loans: These are generally loans that pay off in five years (or less), which are paid off with a fixed monthly payment. Longer loans are available, but you'll spend more on interest and risk losing your loan, which means your loan will exceed the resale value of your car if you stretch things too far for a lower payment.
Mortgage loans: These are usually 15 or 30 year fixed rate mortgages that have a fixed payment schedule, but there are also adjustable rate mortgages (ARMs). With ARMs, the lender can adjust the rate on a predetermined schedule, which would affect your payment schedule.
Most people don't keep the same home loan for 15 or 30 years (they sell the house or refinance the loan at some point), but these loans work as if they were held for the entire term.
Personal loans: These loans, which you can get from a bank, credit union, or online lender, are generally amortized loans as well. They typically have three-year terms, fixed interest rates, and fixed monthly payments. They are often used for small projects or debt consolidation.
Loans that are not amortized
Some loans have no amortization. They include:
- Credit cards: With them, you can repeatedly request a loan on the same card, and you can choose how much to pay each month, as long as you meet the minimum payment. These types of loans are also known as revolving debt.
- Interest-Only Loans: These loans are also not repaid, at least not at first. During the interest-only period, you will only pay principal if you make optional additional payments that exceed the cost of interest. At some point, the lender will ask you to start paying the principal and interest in an amortization schedule or to pay off the loan in full.
- Global Loans: This type of loan requires you to make a large principal payment at the end of the loan. During the first few years of the loan, you will make small payments, but the entire loan will eventually mature. In most cases, you will probably refinance your down payment unless you have a large amount of cash.
Analyzing the amortization is useful if you want to understand how the loan works. Consumers generally make decisions based on an affordable monthly payment, but interest costs are the best way to measure the true cost of what you buy.
Sometimes a lower monthly payment actually means you will pay more interest. For example, if you extend the repayment term, you will pay more interest than you would for a shorter repayment term.
With the information organized in an amortization table, it is easy to evaluate different loan options. You can compare lenders, choose a 15- or 30-year loan, or decide if you want to refinance an existing loan.
You can even calculate how much you would save by paying the debt up front. With most loans, you can skip all the remaining interest expenses by paying them off early.
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